Dividend stocks are a powerful investment for the long-term, and most investors looking for income have few options right now in a low interest rate environment.
However, these facts don’t mean that dividend stocks are always the best investment — especially if you are hoping for capital gains in addition to the dividend potential.
Mebane Faber of Cambria Investment Management recently pointed out that dividend stocks normally trade at a deep discount to the broader market, including a period in 1997 when the P/E of defensive sectors was sometimes as much as 40% below the relative P/E of the broader market.
But right now, defensive dividend stocks are actually trading at a premium of 20% … which could mean underperformance and deep declines if that ratio corrects.
Consider that dividend stalwarts like Coca-Cola (KO), which is up just 9% vs. a 24% run for the market in 2013, have grossly underperformed year-to-date. And more recently, the drop-off in defensive dividend players has been accelerating. While the S&P 500 is up 8% since September 1, some defensive plays like Merck (MRK) are in the red and others including Walmart (WMT) and Caterpillar (CAT) are barely hanging on to 1% gains.
Sure, long-term and income investors should consider dividend stocks a powerful part of their portfolio. But don’t be fooled into thinking that these defensive stocks are your best bet just because they boast big brands and offer decent yield.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.